The Downside of Market-Proof Annuities

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WAITING GAME

With the GMIB, an investor opens an account and transfers a one-time sum or builds up savings over years. Before lifetime income payments can begin, Prudential imposes a seven-year waiting period. It guarantees an annual 5% rate of return, so a $100,000 investment would produce $140,708 seven years later. But if your investments appreciate by more than the guaranteed 5%, you can step up the value of your account and lock in the guarantee on the actual worth. The 5% return then kicks in on that amount. You can do this twice; each time restarts the waiting period.

After seven years, you're free to start receiving lifetime payments. To calculate the minimum you'll get, Prudential takes your account's guaranteed value—$140,708, in the above example. Then it factors in an annual growth rate for the assets and divides by your life expectancy. But you'll pay about 2% a year in fees to get that 5% guaranteed return. And when calculating lifetime payouts, Prudential adds five years to your expected time on this earth. That cuts the payments since it spreads that $140,708 over more years.

Moreover, some provisions in the fine print protect Prudential from incurring losses—at your expense. Say the value of your account falls below the amount you invested, to $80,000 from $100,000. Prudential will assess its 2% fee on the full $100,000. So you'd pay $2,000, or 2.5% of the actual $80,000 balance.

The second living benefit—the GMWB—guarantees you can withdraw up to 5% of the amount invested for the rest of your life, starting any time. Again, Prudential assures a 5% return. If the market surges, there are ways to reset your account value so you won't miss out. In one Prudential version, Highest Daily Lifetime Five (HDLF), you can do this daily.

Once you begin withdrawals, the 5% bump-ups stop, though you can still periodically lock in market gains. To reduce odds of a loss, Prudential makes you use one of 11 diversified investments. If the market tanks, it can move money in an HDLF account from stocks to more conservative assets. But when stocks recover, less of the portfolio will take part in the rally.

This form of benefit is tax-inefficient. As with a 401(k), you pay ordinary income tax of up to 35% on profits you withdraw from a GMWB. The same goes for a GMIB. But the tax hit is spread over time, since a portion of the payments, deemed a return of principal, is tax-exempt. With a GMWB, the IRS assumes you withdraw profits first. Until you spend down profits, you'll pay tax on all money you take out.

Shop around for living benefits. Fidelity and Old Mutual have recently introduced lower-cost versions. "We've tried to keep our product fairly straightforward," says Patrick Ferrer, Vice President of Variable Products at Old Mutual. "Clients are buying these things without digesting them." New York Life takes a different tack. It recommends pairing mutual funds with a fixed annuity. For the same investment, these produce a far higher income. Among potential downsides: Unless you buy a death benefit, the insurer can keep what's in your account when you die.